What Is Earn out payments?
Earn out payments are a component of a Purchase Price in a Mergers and Acquisitions (M&A) transaction, where a portion of the total consideration is contingent upon the acquired company achieving specific Financial Performance targets post-acquisition. This mechanism falls under Corporate Finance, acting as a form of Contingent Consideration. These payments are typically designed to bridge Valuation gaps between buyers and sellers who may hold different perspectives on the target company's future prospects30. The buyer pays an initial amount at closing, with additional earn out payments made later if predefined milestones are met over a specified period29.
History and Origin
Earn out provisions gained prominence as a flexible tool to facilitate M&A deals, particularly when there was considerable uncertainty regarding a target company's future performance or when buyers and sellers held divergent views on its value28. This approach allows sellers to potentially realize a higher total sale price if the business performs well, while buyers mitigate the risk of overpaying for uncertain future growth27. The use of earnouts has seen fluctuations, with notable increases during periods of economic uncertainty, as they provide a mechanism to bridge valuation disagreements26. For instance, a surge in the use of earnout provisions was observed in M&A deals after 2021, with their prevalence increasing from approximately 20% in 2021 to 33% in 202325. This trend underscores their utility in navigating market complexities and aligning the interests of both parties24.
Key Takeaways
- Earn out payments are deferred portions of an acquisition price, contingent on future performance.
- They are primarily used to bridge valuation gaps and manage risk in M&A transactions.
- Performance targets can be financial (e.g., revenue, EBITDA) or non-financial (e.g., product milestones).
- Earnouts can benefit sellers by offering higher potential payouts and buyers by reducing upfront risk.
- Clear and precise drafting of earn out provisions is crucial to avoid post-closing disputes.
Formula and Calculation
The calculation of earn out payments varies significantly depending on the specific terms negotiated in the acquisition agreement. Generally, it involves a predefined formula based on the achievement of certain financial or operational metrics. Common metrics include Revenue, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), Net Income, or specific operational milestones like product launches or regulatory approvals23.
A basic formula for an earn out payment based on revenue might be:
Where:
- (\text{Actual Revenue}) is the revenue achieved by the acquired company during the earnout period.
- (\text{Target Revenue}) is the minimum revenue threshold agreed upon for triggering the earnout.
- (\text{Earnout Percentage}) is the agreed-upon percentage of the excess revenue that constitutes the payment.
Alternatively, for an EBITDA-based earnout with a tiered structure, the calculation could involve specific payment amounts triggered by hitting certain EBITDA levels, as seen in some real-world examples22. The specific Financial Reporting standards and definitions of metrics are crucial in defining these calculations.
Interpreting the Earn out payments
Interpreting earn out payments involves understanding the conditions under which these deferred amounts will be received or paid. For sellers, the potential earn out represents upside beyond the initial closing payment, directly tied to the future Financial Performance of the business they are selling. It reflects their confidence in the company's ability to grow. For buyers, earn out payments are a form of Risk Management, allowing them to defer a portion of the Purchase Price until the anticipated performance materializes.
The structure of the earnout period and the metrics chosen are key. For example, if an earnout is tied to Cash Flow generation, it implies that the buyer is focused on the acquired business's ability to generate liquidity. If it's tied to specific product development milestones, it indicates a focus on strategic integration and future market position. The presence of an earnout also highlights that at the time of the transaction, there was likely some level of Information Asymmetry or disagreement on the precise Valuation of the target company.
Hypothetical Example
Consider "InnovateTech," a software startup being acquired by "Global Holdings." InnovateTech's founders believe their new AI-driven product will significantly boost revenue in the next two years, but Global Holdings is more cautious. To bridge this valuation gap, they agree on an earn out payment structure.
Scenario:
- Initial Purchase Price: $50 million
- Earnout Period: 2 years post-acquisition
- Earnout Metric: Annual Recurring Revenue (ARR) for the new AI product
- Earnout Trigger:
- If ARR reaches $10 million in Year 1, an additional $5 million payment.
- If ARR reaches $25 million in Year 2 (cumulative), an additional $15 million payment.
Year 1 Performance: InnovateTech's AI product gains traction, achieving an ARR of $12 million. Since this exceeds the $10 million target, Global Holdings makes the first earn out payment of $5 million to the founders.
Year 2 Performance: The AI product continues its growth, reaching a cumulative ARR of $28 million by the end of Year 2. This surpasses the $25 million target, triggering the second earn out payment of $15 million.
In this example, the earn out payments allowed the sellers to realize more value based on their product's actual Financial Performance, while the buyer's initial outlay was lower, aligning the final Purchase Price with the actual success of the new product.
Practical Applications
Earn out payments are commonly applied in various scenarios within Mergers and Acquisitions, particularly when significant uncertainty exists about a target company's future. One key area is in the acquisition of technology startups, biotech firms, or other companies with substantial future growth potential but limited current revenue or profitability21. In such cases, buyers may be hesitant to pay a high upfront Valuation based purely on projections. Earnouts allow buyers to mitigate this Risk Management concern by tying a portion of the payment to the actual realization of that potential.
Private Equity firms also frequently utilize earn out provisions, especially when acquiring companies where the existing management team's continued involvement is critical for success20. This structure incentivizes the selling owners to remain engaged and drive post-acquisition performance. Earnout agreements are detailed in legal documents, such as the example earn-out agreement filed with the SEC, which specifies terms, conditions, and calculation methodologies19. Furthermore, earnouts can be instrumental in bridging gaps when there are differing views on market conditions or future regulatory approvals that could impact the business18.
Limitations and Criticisms
While earn out payments can be effective in bridging Valuation gaps in Mergers and Acquisitions, they are not without limitations and can frequently lead to disputes. A primary criticism stems from potential ambiguities in earn out terms, which can result in differing interpretations of Financial Performance metrics, timelines, or calculation methods17. Disputes often arise concerning how accounting practices are applied to measure earn out targets, or if the buyer's operational decisions inadvertently or intentionally impact the acquired business's ability to meet those targets16.
Sellers may accuse buyers of mismanaging the acquired business to avoid earn out payments, or manipulating financial results through aggressive accounting or reallocation of expenses15. The integration of the acquired company into the buyer's operations can also complicate the measurement of the target's standalone performance, making it difficult to isolate the impact of the original business on metrics like Revenue or EBITDA. Academic research has highlighted that earnouts can have a substantial potential for conflict, often converting an upfront disagreement over price into future litigation over the outcome14,13. Moreover, accounting for earnouts can be complex, as they are often recorded as a liability on the buyer's Balance Sheet and require remeasurement to fair value at each reporting date, with changes recognized in earnings12,11. This can also impact the calculation of Goodwill in an acquisition10.
Earn out payments vs. Contingent Value Rights
Earn out payments and Contingent Value Rights (CVRs) are both forms of Contingent Consideration used in M&A transactions, but they differ primarily in their application and typical structure.
Earn out payments are typically utilized in private company acquisitions. They involve linking a portion of the Purchase Price to the future performance of the acquired business itself, based on specific financial or operational metrics (e.g., sales, profits, or milestones)9. The payments are made directly to the selling shareholders. This mechanism aims to bridge valuation gaps based on the target company's projected results and often incentivizes the former owners to remain involved in the business post-acquisition.
CVRs, on the other hand, are more common in public company acquisitions or complex transactions. A CVR gives the holder the right to receive a future cash payment or shares upon the occurrence of a specific event, often unrelated to the ongoing operations of the acquired entity but rather tied to external factors or specific product development achievements8. For example, a CVR might be issued in a pharmaceutical acquisition, entitling former shareholders to a payment if a specific drug receives regulatory approval by a certain date. Unlike earn outs, CVRs are often tradable securities. The confusion arises because both mechanisms defer a portion of the total consideration based on future conditions, but the nature of those conditions and the entities they apply to often differ significantly.
FAQs
How long do earn out periods typically last?
Earn out periods vary but commonly range from one to three years, though they can be as short as six months or extend beyond five years, depending on the nature of the business and the specific performance metrics7,6.
Are earn out payments taxed as capital gains or ordinary income?
The tax treatment of earn out payments can be complex and depends on whether the payments are considered part of the deferred Purchase Price or compensation for services. Generally, if tied solely to the sale of the business, they may be treated as capital gains. However, if linked to continued employment or specific services provided by the seller post-acquisition, they might be classified as ordinary income5.
What happens if the performance targets are not met?
If the agreed-upon performance targets are not met during the earn out period, the buyer is typically not obligated to make the earn out payment, or only a partial payment if a sliding scale is in place4. This is a core aspect of the Risk Management feature for the buyer.
Can earn outs be paid in something other than cash?
While cash is the most common form of earn out payment, they can sometimes be settled in other assets or equity units of the acquirer, depending on the terms of the acquisition agreement3,2.
Who typically manages the acquired business during an earn out period?
Management during an earn out period can vary. In many cases, the buyer assumes control of the acquired business, but the selling founders or key executives might remain involved to help achieve the earn out targets, especially if their expertise is critical. The degree of operational control maintained by the buyer is a frequent point of negotiation and can be a source of disputes if not clearly defined1,.